COST ANALYSIS Chapter 6 slide 1

General Principles:

- Only Differential Costs Matter. Ignore Costs that are fixed across Options.

Examples

MBA Degree

City-Owned Land

Surplus Factory Space

Starting a Business

Cost of Capital $100 K at 15%

Revenues $200 KExpenses -$110 K

Your Wage -$65 K

-$15 K

Economic Profit $10 K

- Opportunity Costs Should Not be Ignored.

ORDERING A BEST SELLER

Demand: P = 24 - Q MC = $12 per book

A. Find optimal Q and P.MR = 24 - 2Q = 12Q = 6 hundred, P = $18Cont. = (18 - 12)(600) = $3,600.

B. Suppose average book earns $4 and shelf space is limited.

MC = 12 + 4 (Opp Cost)Q = 4 hundred, P = $20.Cont. = (20 - 16)(400) = $1,600.

C. Suppose demand falls to P = 18 - 2Q.How many of the 400 booksshould the store sell and howmany should it return for $6 each?

MC = 4 + 6 (Opp Cost)MR = 18 - 4Q = 10,Q = 2 hundred, P = $14.Cont. = (14 -16)(200) + (6 - 12)(200) = -$1,600.

6.2

COST ANALYSIS

MC

Short-Run Cost Behavior

Diminishing Marginal Productivityleads to Increasing MC.

Example:MC = Wage/MPL

W = $12/Hr, MPL = 4/Hr then MC = $3/unit

AC

6.3

LONG-RUN COST 6.4

The shape of LR average costdepends upon returns to scale.

Constant LACreflects ConstantReturns to Scale.

SAC1 SAC2 SAC3

Flat LAC reflects Constant Returns to Scale.

With plant fixed,SAC is U-shapedand lies aboveLAC.

OPTIMAL OUTPUT

MC

Q*

P*Demand

MR

MR

Q*

Low Demand versusHigh Demand

AC

6.5

In either case, the firm’sOptimal output occurs where: MR = MC

THE SHUT-DOWN RULE

MC

P*

DemandMR

1. In the long run, the firm should shut down when: P < AC.

AVC

6.6

AC

2. In the short run, the firm should produce Q* because: P > AVC.

Q*